by Rob Bennett

Value Investors need to look at scores of factors to determine whether a stock is worth buying or not. But the entire point of indexing is to make investing simple. Indexers don’t do research. They earn lower returns than effective Value Investors. But it’s okay. They earn good enough returns without having to put much work into the project.

This cool new way to invest is made possible through The Magic of Aggregation.

Say that you wanted to know who was going to win the next election. You could grill one voter, asking him every question about every possible subject, much as Value Investors ask all sorts of questions about the prospects of the company they are thinking of investing in, and it wouldn’t get you far. But when you aggregate a large number of voters, it becomes easy to gain at least a good sense of who is going to win the election. Opinion polls really do work so long as they are performed in a scientific way and the sample size is large enough.

So it is with index investing. When you mix together the companies with good management and the companies with poor management, the companies with an impressive product pipeline and the companies with a weak product pipeline, the companies that have built moats and the companies that have failed to do so, you can know in advance what return you are going to obtain from your investment.

Not precisely. But you can bet that the number is going to be close to 6.5 percent real. That’s been the average long-term return for U.S. stocks for as far back as we have records.

Indexers are learning of late that that word “average” can cause them a whole big bunch of financial pain. The likely long-term return for an index fund purchased at fair-value prices is 6.5 percent real. But the likely long-term return for an index fund purchased at the top of the bubble is a negative 1 percent real. That’s not as good. It’s not even close.

The great thing about indexing is that it lets you avoid the hard work of Value Investing. All the things that Value Investors learn about their investments through research are priced in when you buy a share in an index fund. That’s so cool! It makes investing so easy! Why can’t the effect of valuations be priced in too?

It’s a logical impossibility for the effect of valuations to be priced in. Both overvaluation and undervaluation are mispricings. A mispricing can never be priced in to a market price. If it were, the market price would be accurate and the mispricing would disappear. You can have overvaluation in a non-efficient market and you can have proper pricing in an efficient market but you can never have overvaluation in an efficient market. Once you see the P/E10 value move away from the fair-value mark (a P/E10 of 15), you know that the market you are looking at has lost any efficiency it might have possessed in earlier days.

The implications here are far-reaching.

It’s not just that indexers should take valuations into account when setting their stock allocations. They should of course do that. All investors should of course do that. But that is only half of the lesson we learn when we learn that overvaluation can never be priced in to the market price of an index fund.

The full reality is that the dangers that follow from failing to take valuations into consideration are greater for indexers than they are for any other kinds of investor. Value Investors should consider valuations. But a Value Investor who fails to consider valuations might do okay all the same if his assessments of all the other factors he takes into consideration are sharp enough. Even at times of insane overvaluation, there are some individual companies that are priced to provide solid long-term returns.

No such comforting possibilities exist for the indexer. The Power of Aggregation that makes it possible for indexers to earn good returns without doing any research at times of reasonable prices turns against them at times of insanely high prices. At times of reasonable prices, The Power of Aggregation assures the indexer that all the negative influence of all the bad companies he is buying will be countered by the positive influence of all the good companies he is buying and the overall result will be a long-term return of something in the neighborhood of 6.5 percent real. At times of insane overvaluation, The Power of Aggregation assures instead that his long-term return will be poor.

For an index to provide an average long-term return of 6.5 percent real, it must provide returns far above that at times of low valuations and far below that at times of high valuations. Value Investors can escape the negative of buying at times of overvaluation by virtue of outstanding research efforts. Indexers don’t research. There is no such escape hatch available to them. Indexers who invest heavily in stocks at times of high valuations are doomed.

Valuations always matter. But the effect is concentrated for indexers. Valuations matter far more for indexers than they do for any other type of investor. When indexers are told that they need not engage in long-term timing, they are being led to the slaughter. The downside of following an investing strategy that permits you to ignore all factors other than price is that you absolutely must must, must consider price for so long as you continue to follow that strategy.

Rob Bennett has written extensively on what causes stock price changes. His bio is here.